Student name: Minh Trang Luong

Student number: 5417259

ACCY342

Assessment 2 - Essay

The disclosure of massive financial accounting fraud at WorldCom on June 25, 2002

was a major shock to the public since the company at that time was the second

largest US long-distance carrier and developed the world’s largest Internet protocol

network (Bartholomeusz 2002). It became apparent that WorldCom had overstated

EBITDA by fraudulently capitalizing its expenses (Sadka 2006), which inflated the

company’s reported earnings and cash flows by at least 3.9 billion US dollars

(Bartholomeusz 2002). In July 2002, the company filed for Chapter 11 bankruptcy

with debt of 41 billion US dollar (Sadka 2006). The accounting fraud at WorldCom

resulted in a widespread withdrawal of non-expert trust on the systems of accounting

and auditing (Unerman and O’Dwyer 2003). The weak and ineffective auditing had

led to the largest bankruptcy in the US. It can be seen from the scandal that the lack

of auditors’ independence, breach of fundamental principles of professional ethics

and the lack of effective internal control. The essay will further analyse the three

issues and discuss the relevance of the WorldCom collapse to Australian Auditors.

Firstly, the lack of independence of auditors was one of the main causes of auditing

failure of the WorldCom scandal. Independence is important when complying with

ethical principles to act with integrity and objectivity (Moroney, Campbell and

Hamilton 2017). According to Mautz and Sharaf (1961), the value of an audit report

depends on the degree to which it has been independently produced (as cited in Yip
and Pang 2017). Each accountant is ethically and morally responsible to ensure that

other members of the profession adhere to the idea of intellectual independence

(Church, Jenkins and Stanley 2018). There are two forms of independence which

are independence of mind and independence of appearance (APES 110 as cited in

Moroney, Campbell and Hamilton 2017). While the former is referred as actual

independence where auditors are able to make decisions that are free from bias,

personal beliefs and client pressure, the latter is perceived independence where

auditors must be seen to be independent and ensure that nothing can be done to

compromise their independence of both mind and appearance (Moroney, Campbell

and Hamilton 2017). Auditor independence is widely assumed by financial markets

and is relied on by investors, employees, and strategic partners (Moore et al 2006).

While a corporation’s managers usually have incentives to ‘cook the book’ like in

WorldCom scandal, auditors are supposed to help prevent the company’s financial

reports from threats posed by such incentive (Moore et al 2006). Arthur Andersen,

WorldCom’s external auditor, had been working for WorldCom for over twenty years

(Beresford, Katzebbach, and Rogers 2003), this posed as familiarity threat to

auditor’s independence. Familiarity threat can occur when there is a close

relationship between the assurance firm and the client (Moroney, Campbell and

Hamilton 2017). As a result, auditors might become too sensitive towards the needs

of the clients, thus losing their objectivity (Moroney, Campbell and Hamilton 2017). It

came as a surprise, or rather a suspicion, to both expert and non-expert that

Andersen failed to notice the expense capitalization of WorldCom, thus raising the

question whether Andersen’s audit opinion was independently produced and free

from bias, personal beliefs and client pressure. As mentioned above, auditor’s

independence is crucial as it assures shareholders and creditors about the accuracy

of the company’s financial statements thus improving their decision making process.

Had the WorldCom’s external auditor, Arthur Andersen, been independent,

accounting irregularities could have been detected sooner, thus preventing

shareholders from losses of millions of dollars.

Secondly, the fact that WorldCom breached APES 110 Code of Ethics for

professional accountants has led the company to its collapse and the public’s loss of

trust in accounting and auditing systems. According to the code of ethics, every

member of the accountancy profession is responsible for acting in the public interest

(as cited in Moroney, Campbell and Hamilton 2017). It is important that every

accountant comply with the fundamental ethical principles including integrity,

objectivity, professional competence and due care, confidentiality, and professional

behaviour. It can be seen from the collapse of WorldCom that the accountant and

auditors did not act with integrity and objectivity. Integrity is the obligation that ‘all

members of the professional bodies be straightforward and honest and should not

associate themselves with information that is materially false or misleading.

WorldCom falsely booked 3.85 billion US dollars in expense as capital investment to

make the company appear more profitable (Cernusca 2007). Operating expense

must be subtracted from the revenue immediately while capital expense can be

spread over time (Tran 2002). As a result, the capitalization of expenses had inflated

WorldCom’s profit (Tran 2002). It was clear that the information given in WorldCom’s

financial statement was materially false and misleading since it made investors

believe that the company will remain in business in the foreseeable future, also

known as going concern principle, while it is on the verge of bankruptcy. Additionally,

it seemed that external auditor of WorldCom did not act with objectivity. Objectivity is

considered as the obligation that ‘all members of the professional bodies not allow
their personal feelings or prejudices to influence their judgement’ (Moroney,

Campbell and Hamilton 2017). As mentioned above, there seemed to be a lack of

Andersen’s lack of independence from WorldCom thus leading to biased audit

opinions which have major impact on shareholders and other stakeholders.

Andersen misjudged the risk that WorldCom’s management would engage in fraud

and determined that the risk of fraud was no greater than moderate (Beresford,

Katzebbach, and Rogers 2003). As a consequence, the external auditors did not

devise sufficient auditing procedures to focus on the possibility of fraud (Beresford,

Katzebbach and Rogers 2003). Although members of accounting bodies should be

unbiased and not allow the influence of others to affect their decision process

(Moroney, Campbell and Hamilton 2017), Andersen placed too much reliance on

senior managements perceived integrity and failed to conduct appropriate auditing

procedures to assess the risk (Beresford, Katzebbach, and Rogers 2003) yet gave a

clean opinion about WorldCom financials (Zekany, Braun, and Warder 2004).

Thirdly, ineffective internal control plays a major role in the failure of WorldCom.

Internal control is regarded as an effective and qualified tool for managing an entity

and it is necessary to ensure the rational use of the property and its security

(Gabrevičienė, Petrošienė, and Šidlauskienė 2018). One of the objectives of internal

control is the quality and the integrity of information, thus ensuring users of the

financial reports that the information received in the decision-making process is

relevant, credible and supplied in a timely manner (Dănescu, Prozan, and Dănescu

2012). There are several frameworks that have been developed worldwide that

auditors and organizations can use as a guide to better understand and assess

internal control of the company (Moroney, Campbell and Hamilton 2017). The

framework published by the Committee of Sponsoring Organizations of the

Treadway Commission (COSO) divides internal control into five distinct elements

including control environment, risk assessment, control activities, information and

communication and monitoring (Moroney, Campbell and Hamilton 2017). Control

environment defines individual roles in the company (Moroney, Campbell and

Hamilton 2017). Employees in the company were encouraged to increase profit by

all means, even if it meant falsifying financial statements. Honesty and integrity were

not the core value of the company, thus destroying the company from the inside.

Risk assessment process includes managers’ identification of relevant risk of a

financial report that gives a true and fair view. Senior managers put pressure on

accountants to increase profit by reducing line cost, thus they decided to capitalize

excess capacity costs that were not generating revenue (Zekany, Braun, and Warder

2004). Information system and communication enable managers to make

appropriate decision in controlling the company’s activities. Communication in

WorldCom was considered ineffective as when internal auditors confronted the

executives about the accounting irregularities, they would cast them aside and

denied any access to WorldCom records (Pulliam and Solomon 2002). Effective

internal control provides a major benefit to shareholders as it reduces both

intentional and unintentional material misstatement in measuring, recognizing, and

disclosing financial information (Hu et al 2013). It can be concluded that there was a

lack of effective internal control in WorldCom which had a negative impact on

investors as they were misled into believing that the company was profitable when it

was on the verge of insolvency.

The sudden exposures of unethical behaviour of large companies like Enron and

WorldCom in the US and HIH in Australia have raised the demand for new

legislations and regulatory changes. The year 2002 in the US met with the
introduction of Sarbanes – Oxley Act. It provides strict new laws that deal with

corporate governance, auditor independence and accounting reform, thus increasing

the accountability of directors and senior managers (Dale and Grey 2005). The Act

sets out prohibitions of certain consulting engagements for audit clients. In addition,

there are several principal provisions of the Sarbanes – Oxley Act that affect auditors

independence as they require audit partner rotation of at least once every five years

to prevent any familiarity threat (Robins 2006). Additional provisions increase

penalties and fines for corporate officers who are found to have intentionally

presented misleading financial information so as to avoid material misstatement

(Robins 2006). Although the Act is not directly applied in Australian securities

markets, it has undeniably influenced Australian corporate governance regulations.

Australian regulators, legislators, and the ASX have taken the Sarbanes – Oxley Act

into consideration as they introduced the CLERP 9 amendments to the Corporations

Act in 2004 as well as the ASX Corporate Governance Council’s guidelines. Similar

to Sarbanes – Oxley Act,the amendments aimed to strengthen financial disclosure

and auditors’ independence and integrity (Dale and Grey 2005). It introduced a

stricter set of disclosure requirements for large and listed companies and a more

detailed regulation for audit practices (Robins 2006). The requirements were

designed to strengthen the accountability of company officers for misleading

information in financial reports (Robins 2006) Australian regulators ensure the

independence of auditors by requiring the periodic rotation of audit partners and the

disclosure of non – audit services by the audit company (Edward, Gajic and Lynch

2002). The top 500 companies will also be under the obligation to establish audit

committees if they have not gotten one (Robins 2006). This has a rather desirable

outcome as it ensures that auditor’s selection and independence is enhanced

(Carnegie and O’Connell 2014). It can be seen that CLERP 9, similar to Sarbanes –

Oxley Act, has taken steps to minimize many audit and accounting issues which

occurred from major collapses in the past such as auditor’s independence, integrity

and objectivity as well as material misstatement and the lack of effective internal

control. However, rules alone cannot regulate ethics and prevent misleading or

deceptive conduct completely, many people argue that the root of the misconduct

also lies in the issue in accounting and auditing education. Major collapses in the

world have brought people attention to the importance of ethical behaviour in the

practice of accounting and auditing, thus raising the demand to include ethics in

accounting and auditing education (Gaa and Thorne 2004). Accounting and auditing

students tend to focus on technical practices and rarely consider the ethical value

behind their tasks. As a result, members of the profession just do whatever they are

told to do without raising questions about it, even if their actions are unethical and

potentially harmful to the interest of shareholders and the interest of public. Students’

general perception of business usually lacks ethical and social justice considerations

(Chabrak and Craig 2013). It is important that future accountants and auditors be

more aware of the impact of their profession on the society and act in the best of

public interest. To conclude, the collapse of WorldCom has led to the amendments

of rules and regulations with regards to auditors’ independence and a detailed

disclosure of financial reports as well as the need for a change in education for future

accountants and auditors so as to prevent any major collapse that caused a loss of

millions of dollars.

In conclusion, the lack of auditor’s independence, their breach of APES110 code of

conducts and the lack of effective internal control have led to the WorldCom

manipulation of information in financial statement and the external auditors’ failure to

detect fraudulent risk. Although the collapse of WorldCom happened in the US and

did not affect Australia directly, it has somewhat influenced Australian regulators,

legislators and the ASX as the amendments of rules was based on Sarbanes –

Oxley Act in the US after the scandal and failures of major companies. In addition,

the collapse made people realized that regulations alone will not be sufficient to

solve the problem as we need to educate future accountants and auditors to prevent

major collapses from happening.

Word count: 2124

References:

Bartholomeusz, S 2002, ‘After Enron: The New Reform Debate’, University of New

South Wales Law Journal, no. Issue 2, p. 580, viewed 13 May 2019, <https://search-

ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edshol&AN=edshol.hein.journals.swales25.38&site=eds-live>.

Beresford, D. R., Katzenbach, N. d., & Rogers, C. B. J. (2003). Report of

investigation by the special investigative committee of the board of directors of

WorldCom, inc.

Carnegie, G. D. and O’Connell, B. T. 2014 ‘A longitudinal study of the interplay of

corporate collapse, accounting failure and governance change in Australia: Early

1890s to early 2000s’, Critical Perspectives on Accounting, 25(6), pp. 446–468. doi:

10.1016/j.cpa.2013.04.001.

Church, BK, Jenkins, JG & Stanley, JD 2018., ‘Auditor Independence in the United

States: Cornerstone of the Profession or Thorn in Our Side?’, ACCOUNTING

HORIZONS, vol. 32, no. 3, pp. 145–168, viewed 13 May 2019, <https://search-

ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edswss&AN=000450654100009&site=eds-live>.

Cernusca, L 2007, ‘Ethics in Accounting: The Worldcom Inc. Scandal’, Lex ET

Scientia International Journal, p. 239, viewed 14 May 2019, <https://search-

ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edshol&AN=edshol.hein.journals.lexetsc14.25&site=eds-live>.

Dale, L & Grey, KM, 2005, ‘Australian companies and Sarbanes-Oxley: governance

regulation in a parallel universe’, Keeping Good Companies, (5), p. 284. Available at:
https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edsaup&AN=edsaup.200506366&site=eds-live (Accessed: 23 May

2019).

Dănescu, T, Prozan, M & Dănescu, AC 2012, ‘The Role of the Risk Management

and of the Activities of Internal Control in Supplying useful Information through the

Accounting and Fiscal Reports’, Procedia Economics & Finance, vol. 3, p. 1099,

viewed 17 May 2019, <https://search-ebscohost-

com.ezproxy.uow.edu.au/login.aspx?direct=true&db=edo&AN=85426209&site=eds-

live>.

Edwards, J., Gajic, M. and Lynch, C. (2002) ‘Public company accounting and

investor protection in the United States: implications for Australian corporate

governance from the Sarbanes-Oxley Act’, COMPANY AND SECURITIES LAW

JOURNAL, 20(7). Available at: https://search-ebscohost-

com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edsapt&AN=rmitplus20025087&site=eds-live (Accessed: 23 May

2019).

Gaa, J. C. and Thorne, L. (2004) ‘An Introduction to the Special Issue on

Professionalism and Ethics in Accounting Education’, Issues in Accounting

Education, 19(1), pp. 1–6. Available at: https://search-ebscohost-

com.ezproxy.uow.edu.au/login.aspx?direct=true&db=bth&AN=13379427&site=eds-

live (Accessed: 23 May 2019).

Gabrevičienė, A, Petrošienė, B & Šidlauskienė, D 2018, ‘Internal Audit and Control in

a Company in the Context of Management Activity’, Humanities Bulletin of

Zaporizhzhe State Engineering Academy, no. 74, pp. 190–198, viewed 17 May
2019, <https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=hlh&AN=134141468&site=eds-live>.

Hu, N. et al. (2013) ‘The Impact of Ineffective Internal Control on the Value

Relevance of Accounting Information’, Asia-Pacific Journal of Accounting and

Economics, 20(3), pp. 334–347. doi: http://www-tandfonline-

com.ezproxy.uow.edu.au/loi/raae20#.UcCm9diE7xU.

Moore, D. A. et al. (2006) ‘Conflicts of Interest and the Case of Auditor

Independence: Moral Seduction and Strategic Issue Cycling’, Academy of

Management Review, 31(1), pp. 10–29. doi: 10.5465/AMR.2006.19379621.

Moroney, R, Campbell, F & Hamilton, J 2017, Auditing : a practical approach / Robyn

Moroney, Fiona Campbell, Jane Hamilton, Wiley, viewed 23 May 2019,

<https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=cat03332a&AN=uow.b2906723&site=eds-live>.

Robins, F. (2006) ‘Corporate governance after sarbanes-oxley: An Australian

perspective’, Corporate Governance, 6(1), pp. 34–48. doi:

10.1108/14720700610649445.

Sadka, G. (2006) ‘Economic Consequences of Accounting Fraud in Product Markets:

Theory and a Case from the U.S. Telecommunications Industry (WorldCom),

The’, American Law and Economics Review, (Issue 3), p. 439. Available at:

https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=edshol&AN=edshol.hein.journals.aler8.25&site=eds-live (Accessed:

20 May 2019).
 Pulliam, S. and Solomon, D. (2002). How Three Unlikely SleuthsExposed Fraud at

WorldCom. [online] WSJ. Available at:

https://www.wsj.com/articles/SB1035929943494003751

Tran, M. (2002). WorldCom accounting scandal. [online] the Guardian. Available at:

https://www.theguardian.com/business/2002/aug/09/corporatefraud.worldcom2?

fbclid=IwAR3JUUIJ4XVQe_TjRdUDetCWPcgiJoNZct1SGktE4QQ0lGim_12kGRStdg

c [Accessed 15 May 2019].

Unermanan J.& O’Dwyer B., (20014), Enron, WorldCom, Andersen et al: a challenge

to modernity, Critical Perspectives on Accounting 15 (2004) 971–993.

Yip and Pang, E. (2017) ‘Investors’ perceptions of auditor independence: Evidence

from Hong Kong’, e-Journal of Social & Behavioural Research in Business, 8(2), pp.

70–82. Available at: https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=sih&AN=127698496&site=eds-live (Accessed: 23 May 2019).

Zekany, KE, Braun, LW & Warder, ZT 2004, ‘Behind Closed Doors at WorldCom:

2001’, Issues in Accounting Education, vol. 19, no. 1, pp. 101–117, viewed 14 May

2019, <https://search-ebscohost-com.ezproxy.uow.edu.au/login.aspx?

direct=true&db=bth&AN=13379445&site=eds-live>